FINANCIAL STATEMENT ANALYSIS

The major objectives of financial statement analysis are as follows:

1. Assessment of Past Performance

Past performance is a good indicator of future performance. Investors or creditors are interested in the
trend of past sales, cost of goods sold, operating expenses, net income, cash flows and return on
investment. These trends offer a means for judging management's past performance and are possible
indicators of future performance.

2. Assessment of current position
Financial statement analysis shows the current position of the firm in terms of the types of assets
owned by a business firm and the different liabilities due against the enterprise.

3. Prediction of profitability and growth prospects
Financial statement analysis helps in assessing and predicting the earning prospects and growth rates
in earning which are used by investors while comparing investment alternatives and other users in
judging earning potential of business enterprise.

4. Prediction of bankruptcy and failure
Financial statement analysis is an important tool in assessing and predicting bankruptcy and
probability of business failure.

5. Assessment of the operational efficiency
Financial statement analysis helps to assess the operational efficiency of the management of a
company. The actual performance of the firm which is revealed in the financial statements can be
compared with some standards set earlier and the deviation of any between standards and actual
performance can be used as the indicator of efficiency of the management.

General Approach to FS Analysis
1. Traditional approach - use of ratio analysis, horizontal and vertical
2. Modern approach both internal and external business environment are taken into consideration.
The approach is futuristic as opposed to traditional approach.


Common Size/Vertical Analysis



Trend Analysis/Horizontal Analysis

VS

Financial Ratio Analysis

Question Category of Ratios Used
1. How liquid is the firm? Will it be able to pay its
bill as they become due?
LIQUIDITY RATIOS
2. How has the firm financed the purchase of its
assets?
CAPITAL STRUCTURE RATIOS
3. How efficient has the firms management been
in utilizing its assets to generate sales?
ASSET MANAGEMENT EFFICIENCY RATIOS
4. Has the firm earned adequate returns on
investment?
PROFITABILITY RATIOS
5. Are the firms managers creating value for
shareholders?
MARKET VALUE RATIOS


A. LIQUIDITY RATIOS short term solvency

RATIO FORMULA FUNCTION
1. Working
Capital
Current assets Current Liabilities
It measures how much in liquid assets a company
has available to build its business.
2. Current Ratio Current Assets Current Liabilities
Ability to repay short-term commitments
promptly. (Short-term Solvency) Ideal Ratio is
2:1.High Ratio indicates existence of idle current
assets.
3. Quick Ratio
or Acid test
ratio
(Current Assets - Inventory &
Prepaid Assets) Current Liabilities
Ability to meet immediate liabilities. Ideal
Ratio is 1.33:1
4. Absolute Cash
Ratio
(Cash + Marketable Securities)
Current Liabilities
Availability of cash to meet short-term
commitments.

Can a Firm Have Too Much Liquidity? A high investment in liquid assets will enable the firm to repay its
current liabilities in a timely manner. However, an excessive investment in liquid assets can prove to be
costly as liquid assets generate minimal return.

B. CAPITAL STRUCTURE RATIOS

RATIO FORMULA FUNCTION
1. Times
Interest
Earned
EBIT Interest Expense
Indicates the extent to which operations cover
interest expense
2. Debt Ratio Total Liabilities Total Assets
Measures the proportion of the firms assets that
are financed by borrowing or debt financing.
3. Equity Ratio Total SHE Total Assets
Measures the proportion of the firms assets that
are financed by owners.
4. Debt Equity
Ratio
Total Liabilities Total SHE
Measures the proportion of assets provided by
creditors compared to that provided by owners. ;
Ideal ratio is 2:1.
5. Fixed Asset to
Long-term
Liabilities
Fixed Asset Long-term Liabilities
Reflect the extent of the utilization of resources
from long-term debt. Indicates sources of
additional funds.
6. Fixed Asset to
Total Equity
Fixed Asset Total Equity
Indicates the over or under investment by
owners.
7. Fixed Assets
to Total
Assets
Net Fixed Asset Total Assets Indicates possible over expansion of PPE
8. BPS on CS CS equity # of CS Outstanding
Measures recoverable amount in the event of
liquidation if assets are realized at their BV.
9. Times
Preferred
Dividend
requirements
Net Income after Tax Preferred
Dividend Requirement
Indicates ability to provide dividends to preferred
shareholders
10. Times Fixed
Charges
Earned
Net Income before Taxes and Fixed
Charges Fixed Charges
FC=rent+ interest+ sinking fund
payment before taxes
Indicates ability to cover fixed charges.
C. ASSET MANAGEMENT EFFICIENCY RATIOS

RATIO FORMULA FUNCTION
1. Accounts
Receivable
Turnover
Annual Credit Sales Ave. Accounts
Receivable
Measures how many times accounts receivable
are rolled over during a year
2. Average
Collection
Period
Accounts Receivable Daily Credit
Sales
or
365 Receivable Turnover
Measures how fast the firm collects its accounts
receivables
3. Inventory
Turnover
Cost of Goods Sold Ave. Inventory
Measures how many times the company turns
over its inventory during the year.
4. Average Age
of Inventory
Inventory Daily COGS
or
365 Inventory Turnover
Indicates the number of days before an inventory
is sold. Shorter inventory cycles lead to greater
liquidity since the items in inventory are
converted to cash more quickly.
5. Operating
Cycle
Average Collection Period + Average
Age of Inventory
Indicates the number of days it takes for
inventories to be converted into cash. The shorter
the better.
6. Trade
Payables
Turnover
Net Credit Purchases Ave. Trade
Payables
This measurement of liquidity measures the
number of times account payables turnover in
one year. Low turnover is indicative of cash flow
problems.
7. Average Age
of Trade
Payables
365 Payables Turnover
Indicates the number of days it takes for payables
to be paid. The longer the better
8. Cash Flow
Cycle
Operating Cycle - Average Age of
Trade Payables
Indicates how fast the company purchases
inventories, sell it to customers, collect payment
and pay its suppliers.
9. Current Asset
Turnover
[COGS + OPEX(excluding depreciation
& amortization)] Ave. Current
Assets
Measures the movement and utilization of current
assets to meet operating requirements
10. Working
Capital to
Total Asset
Working Capital Total Asset
Indicates relative liquidity of total assets and
distribution of resources employed.
11. Working
Capital
Turnover
Net Sales Ave. Working Capital Indicates adequacy and activity of working capital
11. Sales to Fixed
Assets (Plant
Turnover)
Net Sales Net Fixed Assets
Test roughly the efficiency of management in
keeping plant properties employed
12. Asset
Turnover
Sales Total Asset
Indicates the revenue generated by total assets.
The higher the better.
13. Fixed Asset
Turnover
Sales Net Fixed Asset
Measures firms efficiency in utilizing its fixed
assets.

D. PROFITABILITY RATIOS

RATIO FORMULA FUNCTION
1. Gross Profit
Ratio
Gross Profit Net Sales
It shows how well the firms management
controls its expenses to generate profits.
2. Return on Sales Income Net Sales
Indicates the amount of income earned for
every peso sale.
3. Operating Profit
Ratio
EBIT Net Sales
It indicates how well the firm is managing its
income statement.
4. Return on Total
Asset (ROA)
Income Ave Total Assets
Indicate the efficiency of managers in using
total assets in operating the business.
5. Return on
Owners Equity
(ROE)
Net Income Ave. Equity Indicates the amount earned on investment.
6. Earnings Per
Share
(Net Income Preferred dividends
Requirement) Weighted Ave # of CS
Indicate the amount of income earned by each
common share.
7. Rate of Return
on Current
Assets
Net Income / Ave Current Assets
Indicates the profitability of current assets
invested.
***** Du Pont Method: ROE = ROS(Profitability) x Asset Turnover(Efficiency) x Equity Multiplier
E. MARKET VALUE RATIOS

RATIO FORMULA FUNCTION
1. Price/Earnings
Ratio
Price per share Earnings per share
Indicates the number of pesos required to pay 1
peso of earnings
2. Dividend Yield Dividend per share Price per share
Indicates the rate of return in the investors CS
investment
3. Dividend Pay-
out
Common Dividend per share EPS
Indicates the portion of earnings distributed as
dividends


The Limitations of Ratio Analysis

1. Picking an industry benchmark can sometimes be difficult.
2. Published peer-group or industry averages are not always representative of the firm being analyzed.
3. An industry average is not necessarily a desirable target or norm.
4. Accounting practices differ widely among firms.
5. Many firms experience seasonal changes in their operations.
6. Financial ratios offer only clues. We need to analyze the numbers in order to fully understand the
ratios.
7. The results of financial analysis are dependent on the quality of the financial statements.













































Assignment: Answers to be given next meeting

1. Russell Securities has P100 million in total assets and its corporate tax rate is 40 percent. The
company recently reported that its basic earning power (BEP) ratio was 15 percent and that its
return on assets (ROA) was 9 percent. What was the companys interest expense?

2. A firm has a profit margin of 15 percent on sales of P20,000,000. If the firm has debt of P7,500,000,
total assets of P22,500,000, and an after-tax interest cost on total debt of 5 percent, what is the
firm's ROA?

3. Tapley Dental Supply Company has the following data:

Net income: P240 Sales: P10,000 Total assets: P6,000
Debt ratio: 75% TIE ratio: 2.0 Current ratio: 1.2
BEP ratio: 13.33%

If Tapley could streamline operations, cut operating costs, and raise net income to P300, without
affecting sales or the balance sheet (the additional profits will be paid out as dividends), by how
much would its ROE increase?

4. Your company had the following balance sheet and income statement information for 2003:
Balance sheet:
Cash P 20
A/R 1,000
Inventories 5,000
Total C.A. P 6,020 Debt P 4,000
Net F.A. 2,980 Equity 5,000
Total Assets P 9,000 Total claims P 9,000

Income statement:
Sales P10,000
Cost of goods sold 9,200
EBIT P 800
Interest (10%) 400
EBT P 400
Taxes (40%) 160
Net Income P 240

The industry average inventory turnover is 5. You think you can change your inventory control
system so as to cause your turnover to equal the industry average, and this change is expected to
have no effect on either sales or cost of goods sold. The cash generated from reducing inventories
will be used to buy tax-exempt securities which have a 7 percent rate of return. What will your
profit margin be after the change in inventories is reflected in the income statement?

5. Ruth Company currently has P1,000,000 in accounts receivable. Its days sales outstanding (DSO) is
50 days (based on a 365-day year). Assume a 365-day year. The company wants to reduce its DSO
to the industry average of 32 days by pressuring more of its customers to pay their bills on time.
The company's CFO estimates that if this policy is adopted the company's average sales will fall by
10 percent. Assuming that the company adopts this change and succeeds in reducing its DSO to 32
days and does lose 10 percent of its sales, what will be the level of accounts receivable following the
change?

6. The Meryl Corporation's common stock is currently selling at P100 per share, which represents a
P/E ratio of 10. If the firm has 100 shares of common stock outstanding, a return on equity of 20
percent, and a debt ratio of 60 percent, what is its return on total assets (ROA)?

7. Oliver Incorporated has a current ratio = 1.6, and a quick ratio equal to 1.2. The company has P2
million in sales and its current liabilities are P1 million. What is the companys inventory turnover
ratio?

8. Kansas Office Supply had P24,000,000 in sales last year. The companys net income was P400,000.
Its total assets turnover was 6.0. The companys ROE was 15 percent. The company is financed
entirely with debt and common equity. What is the companys debt ratio?


9. The Merriam Company has determined that its return on equity is 15 percent. Management is
interested in the various components that went into this calculation. You are given the following
information: total debt/total assets = 0.35 and total assets turnover = 2.8. What is the profit
margin?

10. Harvey Supplies Inc. has a current ratio of 3.0, a quick ratio of 2.4, and an inventory turnover ratio
of 6. Harvey's total assets are P1 million and its debt ratio is 0.20. The firm has no long-term debt.
What is Harvey's sales figure?

11. Collins Company had the following partial balance sheet and complete annual income statement:
Partial Balance Sheet:
Cash P 20
A/R 1,000
Inventories 2,000
Total current assets P 3,020
Net fixed assets 2,980
Total assets P 6,000


Income Statement:
Sales P10,000
Cost of goods sold 9,200
EBIT P 800
Interest (10%) 400
EBT P 400
Taxes (40%) 160
Net Income P 240

The industry average DSO is 30 (based on a 365-day year). Collins plans to change its credit policy
so as to cause its DSO to equal the industry average, and this change is expected to have no effect on
either sales or cost of goods sold. If the cash generated from reducing receivables is used to retire
debt (which was outstanding all last year and which has a 10 percent interest rate), what will
Collins' debt ratio (Total debt/Total assets) be after the change in DSO is reflected in the balance
sheet?

12. Last year, Quayle Energy had sales of P200 million, and its inventory turnover ratio was 5.0. The
companys current assets totaled P100 million, and its current ratio was 1.2. What was the
companys quick ratio?